Tax Compliance, the IRS, and Tax Authorities

Transcription

1 chapter 2 Tax Compliance, the IRS, and Tax Authorities Learning Objectives Upon completing this chapter, you should be able to: LO 2-1 Identify the filing requirements for income tax returns and the statute of limitations for assessment. LO 2-2 Outline the IRS audit process, how returns are selected, the different types of audits, and what happens after the audit. LO 2-3 Evaluate the relative weights of the various tax law sources. LO 2-4 Describe the legislative process as it pertains to taxation. Perform the basic steps in tax research and evaluate various tax law sources when faced with ambiguous statutes. LO 2-6 Describe tax professional responsibilities in providing tax advice. LO 2-7 Identify taxpayer and tax professional penalties.

2 Storyline Summary Taxpayers: Family description: Employment status: Filing status: Current situation: Bill and Mercedes Bill and Mercedes are married with one daughter, Margaret. Bill is an economics professor; Mercedes is a small business owner. Married, filing jointly Bill and Mercedes face an IRS audit involving a previous year s interest deductions. Bill and Mercedes received a notice from the Internal Revenue Service (IRS) that their return is under audit for certain interest deductions. As you might expect, they are quite concerned, especially because it has been several years since they claimed the deductions and they worry that all their supporting documentation may not be in place. Several questions run through their minds. How could the IRS audit a return that was filed so long ago? Why was their tax return selected, and what should they expect during the audit? The interest deductions they reported were based on advice from their CPA. What would cause the IRS and a CPA to interpret the law differently? What is their financial exposure if the deductions are ultimately disallowed? Will they have to pay interest and penalties in addition to the tax they might owe? 2-1

3 2-2 CHAPTER 2 Tax Compliance, the IRS, and Tax Authorities Even the most conservative taxpayer is likely to feel anxiety after receiving an IRS notice. This chapter will help answer Bill and Mercedes s questions and provide an overview of the audit process and tax research. While all taxpayers should understand these basics of our tax system, aspiring accountants should be especially familiar with them. LO 2-1 TAXPAYER FILING REQUIREMENTS To file or not to file? Unlike Hamlet s to be or not to be, this question has a pretty straightforward answer. Filing requirements are specified by law for each type of taxpayer. All corporations must file a tax return annually regardless of their taxable income. Estates and trusts are required to file annual income tax returns if their gross income exceeds $ The filing requirements for individual taxpayers are a little more complex. Specifically, they depend on the taxpayer s filing status (single, married filing jointly, and so on, discussed in more detail in Chapter 4), age, and gross income (income before deductions). Exhibit 2-1 lists the 2014 gross income thresholds for taxpayers based on their filing status, gross income, and age. As detailed in Exhibit 2-1, the gross income thresholds are calculated as the sum of the standard deduction, additional deductions for taxpayers age 65 or older, and personal exemption(s) that apply to each respective filing status. 2 These amounts are indexed for inflation and thus change each year. For certain taxpayers such as the self-employed and those claimed as dependents by another taxpayer, lower gross income thresholds apply. EXHIBIT Gross Income Thresholds by Filing Status Filing Status and Age 2014 (in 2014) Gross Income Explanation Single $10,150 $6,200 standard deduction 1 $3,950 personal exemption Single, 65 or older $11,700 $6,200 standard deduction 1 $1,550 additional deduction 1 $3,950 personal exemption Married, filing a joint return $20,300 $12,400 standard deduction 1 $7,900 personal exemptions (2) Married, filing a joint return, $21,500 $12,400 standard deduction 1 $1,200 additional one spouse 65 or older deduction 1 $7,900 personal exemptions (2) Married, filing a joint return, $22,700 $12,400 standard deduction 1 $2,400 additional both spouses 65 or older deductions (2) 1 $7,900 personal exemptions (2) Married, filing a separate return $ 3,950 $3,950 personal exemption Head of household $13,050 $9,100 standard deduction 1 $3,950 personal exemption Head of household, 65 or older $14,600 $9,100 standard deduction 1 $1,550 additional deduction 1 $3,950 personal exemption Surviving spouse with a $16,350 $12,400 standard deduction 1 $3,950 personal dependent child exemption Surviving spouse, 65 or older, $17,550 $12,400 standard deduction 1 $1,200 additional with a dependent child deduction 1 $3,950 personal exemption Whether a taxpayer is due a refund (which occurs when taxes paid exceed tax liability) does not determine whether a taxpayer must file a tax return. Gross income determines whether a tax return is required. Further, note that a taxpayer whose 1 Estates file income tax returns during the administration period (i.e., before all of the estate assets are distributed). 2 IRC We describe the standard deduction and personal exemptions in detail later in the text.

4 CHAPTER 2 Tax Compliance, the IRS, and Tax Authorities 2-3 gross income falls below the respective threshold is not precluded from filing a tax return. Indeed, taxpayers due a refund should file a tax return to receive the refund (or claim a refundable tax credit), even if they are not required to file a tax return. Tax Return Due Date and Extensions Like the filing requirements, due dates for tax returns vary based on the type of taxpayer. Individual tax returns are due on the fifteenth day of the fourth month following year-end that is, April 15 for calendar year individuals. (Due dates that fall on a Saturday, Sunday, or holidays are automatically extended to the next day that is not a Saturday, Sunday, or holiday.) Similarly, partnership returns are also due on the fifteenth day of the fourth month following the partnership s year-end. For corporations, tax returns must be filed by the fifteenth day of the third month following the corporation s year-end (March 15 for calendar-year corporations). Any individual or corporation unable to file a tax return by the original due date can, by that same deadline, request a six-month extension to file, which is granted automatically by the IRS. Similarly, partnerships may request an automatic five-month extension to file. An extension allows the taxpayer to delay filing a tax return but does not extend the due date for tax payments. Thus, when a taxpayer files an extension, she must estimate how much tax will be owed. If a taxpayer fails to pay the entire balance of tax owed by the original due date of the tax return, the IRS charges the taxpayer interest on the underpayment from the due date of the return until the taxpayer pays the tax. 3 The interest rate charged depends on taxpayer type (individual or corporation) and varies quarterly with the federal short-term interest rate. 4 For example, the interest rate for tax underpayments for individuals equals the federal short-term rate plus three percentage points. 5 What happens if the taxpayer does not file a tax return by the time required, whether April 15 or an extended deadline? As you might guess, the IRS imposes penalties on taxpayers failing to comply with the tax law. In many cases, the penalties can be quite substantial (see later discussion in this chapter). In the case of failure to file a tax return, the penalty equals 5 percent of the tax due for each month (or partial month) that the return is late. However, the maximum penalty is generally 25 percent of the tax owed, and the failure to file penalty does not apply if the taxpayer owes no tax. Statute of Limitations Despite the diligent efforts of taxpayers and tax professionals, it is quite common for tax returns to contain mistakes. Some may be to the taxpayer s advantage and others may be to the government s advantage. Regardless of the nature of the mistake, the taxpayer is obligated to file an amended return to correct the error (and request a refund or pay a deficiency) if the statute of limitations has not expired for the tax return. Likewise, the IRS can propose adjustments to the taxpayer s return if the statute of limitations for the return has not expired. By law, the statute of limitations defines the period in which the taxpayer can file an amended tax return or the IRS can assess a tax deficiency for a specific tax year. For both amended tax returns filed by a taxpayer and proposed tax assessments by the IRS, the statute of limitations generally ends three years from the later of (1) the date the tax return was actually filed or (2) the tax return s original due date. The statute of limitations for IRS assessment can be extended in certain circumstances. For example, a six-year statute of limitations applies to IRS assessments if the taxpayer omits items of gross income that exceed 25 percent of the gross income THE KEY FACTS Filing Requirements and Due Dates Filing requirements Specified by law for each type of taxpayer. For individuals, filing requirements vary by filing status, gross income, and age. Gross income thresholds are indexed each year for inflation. Due dates The due date for tax returns varies based on the type of taxpayer. Individual tax returns are due on April 15 for calendar-year individuals. Due dates that fall on a Saturday, Sunday, or holiday are automatically extended to the next day that is not a Saturday, Sunday, or holiday. Any taxpayer unable to file a tax return by the original due date can request an extension to file. An extension allows the taxpayer to delay filing a tax return but does not extend the due date for tax payments. 3 The tax law also imposes a penalty for late payment in addition to the interest charged on the underpayment. We briefly discuss this penalty later in the chapter and in Chapter 7. 4 The federal short-term rate is determined from a one-month average of the market yields from marketable obligations of the United States with maturities of three years or less. 5 This same interest rate applies to individuals who overpay their taxes (i.e., receive a tax refund and interest payment as a result of an IRS audit or from filing an amended tax return).

5 2-4 CHAPTER 2 Tax Compliance, the IRS, and Tax Authorities Example 2-1 reported on the tax return. For fraudulent returns, or if the taxpayer fails to file a tax return, the news is understandably worse. The statute of limitations remains open indefinitely in these cases. Bill and Mercedes file their 2010 federal tax return on September 6, 2011, after receiving an automatic extension to file their return by October 17, In 2014, the IRS selects their 2010 tax return for audit. When does the statute of limitations end for Bill and Mercedes s 2010 tax return? Answer: Assuming the six-year and unlimited statute of limitation rules do not apply, the statute of limitations ends on September 6, 2014 (three years after the later of the actual filing date and the original due date). What if: When would the statute of limitations end for Bill and Mercedes for their 2010 tax return if the couple filed the return on March 22, 2011 (before the original due date of April 18, 2011)? Answer: In this scenario the statute of limitations would end on April 18, 2014, because the later of the actual filing date and the original due date is April 18, Taxpayers should prepare for the possibility of an audit by retaining all supporting documents (receipts, cancelled checks, etc.) for a tax return until the statute of limitations expires. After the statute of limitations expires, taxpayers can discard the majority of supporting documents but should still keep a copy of the tax return itself, as well as any documents that may have ongoing significance, such as those establishing the taxpayer s basis or original investment in existing assets like personal residences and long-term investments. LO 2-2 IRS AUDIT SELECTION Why me? This is a recurring question in life and definitely a common taxpayer question after receiving an IRS audit notice. The answer, in general, is that a taxpayer s return is selected for audit because the IRS has data suggesting the taxpayer s tax return has a high probability of a significant understated tax liability. Budget constraints limit the IRS s ability to audit a majority or even a large minority of tax returns. Currently, fewer than 2 percent of all tax returns are audited. Thus, the IRS must be strategic in selecting returns for audit in an effort to promote the highest level of voluntary taxpayer compliance and increase tax revenues. Specifically, how does the IRS select tax returns for audit? The IRS uses a number of computer programs and outside data sources (newspapers, financial statement disclosures, informants, and other public and private sources) to identify tax returns that may have an understated tax liability. Common computer initiatives include the DIF (Discriminant Function) system, document perfection program, and information matching program. The most important of these initiatives is the DIF system. The DIF system assigns a score to each tax return that represents the probability the tax liability on the return has been underreported (a higher score 5 a higher likelihood of underreporting). The IRS derives the weights assigned to specific tax return attributes from historical IRS audit adjustment data from the National Research Program. 6 The DIF system then uses these (undisclosed) weights to score each tax return based on the tax return s characteristics. Returns with higher DIF scores are then reviewed to determine whether an audit is the best course of action. 6 Similar to its predecessor, the Taxpayer Compliance Measurement Program, the National Research Program (NRP) analyzes a large sample of tax returns that are randomly selected for audit. From these randomly selected returns, the IRS identifies tax return characteristics (e.g., deductions for a home office, unusually high tax deductions relative to a taxpayer s income) associated with underreported liabilities, weights these characteristics, and then incorporates them into the DIF system. The NRP analyzes randomly selected returns to ensure that the DIF scorings are representative of the population of tax returns.

6 CHAPTER 2 Tax Compliance, the IRS, and Tax Authorities 2-5 All returns are checked for mathematical and tax calculation errors, a process referred to as the document perfection program. Individual returns are also subject to the information matching program. This program compares the taxpayer s tax return to information submitted to the IRS from other taxpayers like banks, employers, mutual funds, brokerage companies, and mortgage companies. Information matched includes items such as wages (Form W-2 submitted by employers), interest income (Form 1099-INT submitted by banks), and dividend income (Form 1099-DIV submitted by brokerage companies). For tax returns identified as incorrect via the document perfection and information matching programs, the IRS recalculates the taxpayer s tax liability and sends a notice explaining the adjustment. If the taxpayer owes tax, the IRS will request payment of the tax due. If the taxpayer overpaid tax, the IRS will send the taxpayer a refund of the overpayment. In addition to computer-based methods for identifying tax returns for audit, the IRS may use a number of other audit initiatives that target taxpayers in certain industries, engaged in certain transactions like the acquisition of other companies, or having specific attributes like home office deductions. Taxpayers of a given size and complexity, such as large publicly traded companies, may be audited every year. TAXES IN THE REAL WORLD Turning in Your Neighbor Can Pay Big Bucks The Wall Street Journal reported that in April 2011 the IRS paid its first payment under its new taxpayer whistleblower program that promises large rewards for turning in tax cheats. Under the large-award whistleblower program (where unpaid taxes, interest, and penalties exceed $2 million and the tax cheat, if an individual, had gross income exceeding $200,000 in at least one year), whistleblowers can be paid between 15 and 30 percent of the taxes, interest, and penalties collected by the IRS. Under the smallaward whistleblower program (tax, interest, and penalty underpayments of $2 million or less), the IRS may pay whistleblowers up to 15 percent of the unpaid taxes and interest collected. Whistleblowers use IRS Form 211 ( to apply for the program, and as you might expect, all whistleblower payments received are fully taxable. In its first payment, the IRS paid $4.5 million to a former in-house accountant for a large financial services firm. Given the potential windfall to whistleblowers, you might expect a long line of concerned citizens applying for the program. You would be correct. As of fall 2011, the IRS had received more than 1,000 qualified submissions for the program, involving approximately 10,000 suspected tax cheats. Based on: Taxes: How to Turn in Your Neighbor to the IRS, The Wall Street Journal, WSJ.com, September 3, THE KEY FACTS IRS Audit Selection The IRS uses a number of computer programs and outside data sources to identify tax returns that may have an understated tax liability. Common computer initiatives include the DIF (Discriminant Function) system, document perfection program, and information matching program. The DIF system assigns a score to each tax return that represents the probability the tax liability on the return has been underreported. The document perfection program checks all returns for mathematical and tax calculation errors. The information matching program compares the taxpayer s tax return to information submitted to the IRS from other taxpayers. How was Bill and Mercedes s tax return selected for audit? Given the audit focus on certain deductions, the IRS likely selected their return for audit because the amount or type of the deductions resulted in a high DIF score. IRS personnel then determined that the deductions warranted further review and, thus, selected the tax return for audit. ETHICS After Bill and Mercedes s tax return was selected for audit, Bill read on the Internet speculation that filing a paper copy tax return (instead of filing electronically) and extending a tax return decrease the chance of IRS audit. Bill has convinced Mercedes that they need to use these strategies going forward and look for other ways to avoid audit. Has Bill crossed an ethical boundary? Types of Audits The three types of IRS audits are correspondence, office, and field examinations. Correspondence examinations are the most common. These audits, as the name suggests, are conducted by mail and generally are limited to one or two items on the taxpayer s

7 2-6 CHAPTER 2 Tax Compliance, the IRS, and Tax Authorities return. Of the three types of audits, correspondence audits are generally the narrowest in scope and the least complex. The IRS typically requests supporting documentation for one or more items on the taxpayer s return, like charitable contributions deducted, for example. When appropriate documentation is promptly supplied, these audits typically can be concluded relatively quickly. Of course, they can also be expanded to address other issues that arise as a result of the IRS s inspection of taxpayer documents. Office examinations are the second most common audit. As the name suggests, the IRS conducts them at its local office. These audits are typically broader in scope and more complex than correspondence examinations. Small businesses, taxpayers operating sole proprietorships, and middle- to high-income individual taxpayers are more likely, if audited, to have office examinations. In these examinations, the taxpayer receives a notice that identifies the items subject to audit; requests substantiation for these items as necessary; and notifies the taxpayer of the date, time, and location of the exam. Taxpayers may attend the examination alone, with representation, such as their tax adviser or attorney, or simply let their tax adviser or attorney attend on the taxpayer s behalf. Field examinations are the least common audit. The IRS conducts these at the taxpayer s place of business or the location where the taxpayer s books, records, and source documents are maintained. Field examinations are generally the broadest in scope and the most complex of the three audit types. They can last months to years and generally are limited to business returns and the most complex individual returns. What type of exam do you think Bill and Mercedes will have? Because their return is an individual tax return and the audit is restricted to a relatively narrow set of deductions, their return will likely be subject to a correspondence audit. If the audit were broader in scope, an office examination would be more likely. THE KEY FACTS IRS Audits The three types of IRS audits are correspondence, office, and field examinations. After the audit, the IRS will send the taxpayer a 30-day letter, which provides the taxpayer the opportunity to pay the proposed assessment or request an appeals conference. If an agreement is not reached at appeals or the taxpayer does not pay the proposed assessment, the IRS will send the taxpayer a 90-day letter. After receiving the 90-day letter, the taxpayer may pay the tax or petition the U.S. Tax Court to hear the case. If the taxpayer chooses to pay the tax, the taxpayer may then request a refund of the tax and eventually sue the IRS for refund in the U.S. District Court or the U.S. Court of Federal Claims. After the Audit After the examination, the IRS agent provides a list of proposed adjustments (if any) to the taxpayer for review. If he or she agrees to the proposed changes, the taxpayer signs an agreement form (Form 870) and pays the additional tax owed or receives the proposed refund. If the taxpayer disputes the proposed changes, the taxpayer will receive a 30-day letter giving him or her 30 days to either (1) request a conference with an appeals officer, who is independent and resides in a separate IRS division from the examining agent, or (2) agree to the proposed adjustment. An appeals officer would consider the merits of the unresolved issues as well as the hazards of litigation that is, the probability that the IRS will lose if the case is brought to court and the resulting costs of a taxpayer-favorable ruling. If the taxpayer chooses the appeals conference and reaches an agreement with the IRS there, the taxpayer can then sign the Form 870. If the taxpayer and IRS still do not agree on the proposed adjustment at the appeals conference, or the taxpayer chooses not to request an appeals conference, the IRS will send the taxpayer a 90-day letter. See Exhibit 2-2. The 90-day letter (also known as a statutory notice of deficiency) explains that the taxpayer has 90 days to either (1) pay the proposed deficiency or (2) file a petition in the U.S. Tax Court to hear the case. 7 The U.S. Tax Court is a national court whose judges are tax experts and who hear only tax cases. If the taxpayer would like to litigate the case but prefers it to be heard in the local U.S. District Court or the U.S. Court of Federal Claims, the taxpayer must pay the tax deficiency first, then request a refund from the IRS, and then sue the IRS for refund in the court after the IRS denies the refund claim. Why would a taxpayer prefer one trial court over others? To understand this, we must appreciate the basic distinguishing factors of each. First and foremost, it is relatively common for the U.S. Tax Court, local U.S. District Court, or the U.S. Court of Federal Claims to interpret and rule differently on the same basic tax issue. Given a choice of courts, the taxpayer should prefer the court most likely to rule favorably on 7 If the taxpayer lacks the funds to pay the assessed tax, there is legitimate doubt as to whether the taxpayer owes part or all of the assessed tax, or collection of the tax would cause the taxpayer economic hardship or be unfair or inequitable, the taxpayer can request an offer in compromise with the IRS to settle the tax liability for less than the full amount assessed bv completing Form 656.

8 spi62368_ch02_ indd Page /01/14 9:52 PM user-f-w-198 /202/MH02128/spi62368_disk1of1/ /spi62368_pagefiles CHAPTER 2 EXHIBIT 2-2 Tax Compliance, the IRS, and Tax Authorities IRS Appeals/Litigation Process 1a. Agree with proposed adjustment IRS Exam 1b. Disagree with proposed adjustment Pay Taxes Due 30-Day Letter 3a. Agree with proposed adjustment 2a. Request appeals Appeal Confirmed 2b. No taxpayer response 3b. Disagree with proposed adjustment File Suit in U.S. District Court or U.S. Court of Federal Claims 5. IRS denies refund claim File Claim for Refund with the IRS 90-Day Letter 4b. Pay tax 4a. Do not pay tax; Petition Tax Court Tax Court his or her particular issues. The courts also differ in other ways. For example, the U.S. District Court is the only court that provides for a jury trial; the U.S. Tax Court is the only court that allows tax cases to be heard before the taxpayer pays the disputed liability and the only court with a small claims division (hearing claims involving disputed liabilities of $50,000 or less); the U.S. Tax Court judges are tax experts, whereas the U.S. District Court and U.S. Court of Federal Claims judges are generalists. The taxpayer should consider each of these factors in choosing a trial court. For example, if the taxpayer feels very confident in her tax return position but does not have sufficient funds to pay the disputed liability, she will prefer the U.S. Tax Court. If, instead, the taxpayer is litigating a tax return position that is low on technical merit but high on emotional appeal, a jury trial in the local U.S. District Court may be the best option. What happens after the taxpayer s case is decided in a trial court? The process may not be quite finished. After the trial court s verdict, the losing party has the right to request one of the 13 U.S. Circuit Courts of Appeal to hear the case. Exhibit 2-3 depicts the specific appellant courts for each lower-level court. Both the U.S. Tax Court and local U.S. District Court cases are appealed to the specific U.S. Circuit Court of Appeals based on the taxpayer s residence.8 Cases litigated in Alabama, Florida, and Georgia, for example, appeal to the U.S. Circuit Court of Appeals for the 11th Circuit; whereas those tried in Louisiana, Mississippi, and Texas appeal to the 5th Circuit. In 8 Decisions rendered by the U.S. Tax Court Small Claims Division cannot be appealed by the taxpayer or the IRS. 2-7

9 2-8 CHAPTER 2 Tax Compliance, the IRS, and Tax Authorities EXHIBIT 2-3 Federal Judicial System U.S. Supreme Court U.S. Circuit Courts of Appeal (1st 11th Circuits & D.C. Circuit) U.S. Circuit Court of Appeal (Federal Circuit) U.S. District Courts U.S. Tax Court U.S. Court of Federal Claims U.S. Tax Court Small Claims (No Appeal) contrast, all U.S. Court of Federal Claims cases appeal to the U.S. Circuit Court of Appeals for the Federal Circuit (located in Washington, D.C.). Exhibit 2-4 depicts the geographic regions for each of the 11 U.S. Circuit Courts of Appeal defined by numerical region. Not depicted are the U.S. Circuit Court of Appeals for the District of Columbia and the U.S. Circuit Court of Appeals for the Federal Circuit. Through the initial selection of a trial court U.S. District Court, U.S. Tax Court, or U.S. Court of Federal Claims the taxpayer has the ability to determine which circuit court would hear an appeal of the case (the U.S Circuit Court of Appeals based on residence or the U.S. Circuit Court of Appeals for the Federal Circuit). Because alternative circuit courts may interpret the law differently, the taxpayer should consider in choosing a trial-level court the relevant circuit courts judicial histories to determine which circuit court (and thus, which trial court) would be more likely to rule in his or her favor. After an appeals court hears a case, the losing party has one last option to receive a favorable ruling: a petition to the U.S. Supreme Court to hear the case. However, given the quantity of other cases appealed to the U.S. Supreme Court that are of national importance, the Supreme Court agrees to hear only a few tax cases a year with great significance to a broad cross-section of taxpayers, or cases litigating issues in which there has been disagreement among the circuit courts. For most tax cases, the Supreme Court refuses to hear the case (denies the writ of certiorari) and litigation ends with the circuit court decision. Although litigation of tax disputes is quite common, taxpayers should carefully consider the pros and cons. Litigation can be very costly financially and emotionally, and thus it is more appropriately used as an option of last resort, after all other appeal efforts have been exhausted. What is the likely course of action for Bill and Mercedes s audit? It is too soon to tell. Before you can assess the likely outcome of their audit, you need a better understanding of both the audit issue and the relevant tax laws that apply to the issue. The next section explains alternative tax law sources. After we discuss the various sources

10 CHAPTER 2 Tax Compliance, the IRS, and Tax Authorities 2-9 EXHIBIT 2-4 Geographic Boundaries for the U.S. Circuit Courts of Appeal Northern Eastern CA AK Western WA OR NV 9 Central Southern Eastern ID AZ UT MT WY CO 10 NM ND SD NE Northern TX KS Western Western OK 8 MN Northern Eastern IA Eastern Northern Southern MO Western AR Western Western 5 Western LA WI Eastern Eastern Eastern Northern Central Middle IL MS Eastern 7 Southern Western Northern Southern MI Eastern Western Northern Northern IN Southern Western TN KY Middle Northern AL Southern Middle OH Southern 6 Eastern Eastern Northern Northern GA Middle Southern Western Western PA Western Northern SC Southern Middle FL Middle NC NH VT 2 Northern NY 3 Middle Eastern WV VA Western 4 11 Eastern Eastern Southern ME Eastern NJ DE MD DC FED PR 1 MA RI CT VI Southern Southern MP GU HI Source: *U.S. District Court jurisdictions for those states with more than one U.S. District Court are also depicted (for example, the state of Washington is divided into Eastern and Western Districts). Not depicted are the U.S. Circuit Court of Appeals for the District of Columbia and the U.S. Circuit Court of Appeals for the Federal Circuit. of our tax laws, we ll describe how Bill and Mercedes (or their CPA) can research the sources to identify the best possible course of action. 9 TAX LAW SOURCES There are two broad categories of tax authorities: primary authorities and secondary authorities. Primary authorities are official sources of the tax law generated by the legislative branch (statutory authority issued by Congress), judicial branch (rulings by the U.S. District Court, U.S. Tax Court, U.S. Court of Federal Claims, U.S. Circuit Court of Appeals, or U.S. Supreme Court), and executive/administrative branch (Treasury and IRS pronouncements). Exhibit 2-5 displays the most common primary sources, their respective citations, and related explanations. We ll discuss each of these authorities below. Secondary authorities are unofficial tax authorities that interpret and explain the primary authorities, such as tax research services (discussed below), tax articles from professional journals and law reviews, newsletters, and textbooks. For quick questions, practitioners often use the CCH Master Tax Guide or RIA Federal Tax Handbook. Secondary authorities may be very helpful in understanding a tax issue, but 9 Accountants should be mindful to not engage in the unauthorized practice of law. In years past, several court cases have addressed this issue without providing a clear understanding between practicing tax accounting and the unauthorized practice of law. At present, tax accountants are not likely to overstep their responsibilities if they limit their advice to tax issues and leave the general legal advice and drafting of legal documents to attorneys. LO 2-3 LO 2-4

11 2-10 CHAPTER 2 Tax Compliance, the IRS, and Tax Authorities EXHIBIT 2-5 Citations to Common Primary Authorities Statutory Authorities: Citation: Explanation: Internal Revenue Code IRC Sec. 162(e)(2)(B)(i) Section number 162, subsection e, paragraph 2, subparagraph B, clause i Committee Reports: Senate S. Rep. No. 353, 82d Cong., Senate report number 353, Congress number 82, Finance Committee Report 1st Sess. 14 (1951). Congressional session 1, page number 14, year 1951 House Ways and Means H. Rep. No. 242, 82d Cong., House report number 242, Congress number 82, Committee Report 1st Sess. 40 (1951) Congressional session 1, page number 40, year 1951 Administrative Authorities: Citation: Explanation: Final Regulation Reg. Sec (c)(1) Type of regulation (1 5 income tax), code section 217, regulation number 2, paragraph number c, subparagraph number 1 Temporary Regulation Temp. Reg. Sec (c)(1) Same as final regulation Proposed Regulation Prop. Reg. Sec (c)(1) Same as final regulation Revenue Ruling Rev. Rul , C.B. 41 Ruling number (262nd ruling of 1977), volume number of cumulative bulletin , page number 41 Revenue Procedure Rev. Proc , C.B. 272 Procedure number (10th procedure of 1999), volume number of cumulative bulletin , page number 272 Private Letter Ruling PLR Year 2006, week number 01 (1st week of 2006), ruling number 001 (1st ruling of the week) Technical Advice TAM Year 2004, week number 02 (2nd week of 2004), ruling number Memorandum 001 (1st ruling of the week) Judicial Authorities: Citation: U.S. Supreme Court Comm. v. Kowalski, 434 U.S. 77 Volume 434 of the GPO court reporter, page 77, year 1977 (S. Ct., 1977) Comm. v. Kowalski, 98 S. Ct. 315 Volume 98 of the West court reporter, page 315, year 1977 (S. Ct., 1977) Comm. v. Kowalski, 77-2 USTC Volume 77-2 of the CCH court reporter, paragraph 9,748, par. 9,748 (S. Ct., 1977) year 1977 Comm. v. Kowalski, 40 AFTR2d Volume 40 of the RIA AFTR2d court reporter, paragraph , (S. Ct., 1977) year 1977 U.S. Circuit Court of Azar Nut Co. v. Comm., 931 F.2d 314 Volume 931 of the West F.2d court reporter, page 314, Appeals (5th Cir., 1991) circuit 5th, year 1991 Azar Nut Co. v. Comm., 91-1 USTC Volume 91-1 of the CCH USTC court reporter, paragraph 50,257, par. 50,257 (5th Cir., 1991) circuit 5th, year 1991 Azar Nut Co. v. Comm., Volume 67 of the RIA AFTR2d court reporter, paragraph , 67 AFTR2d (5th Cir., 1991) year 1977 U.S. Tax Court Regular decision L.A. Beeghly, 36 TC 154 (1962) Volume 36 of the Tax Court reporter, page 154, year 1962 U.S. Tax Court Memorandum Robert Rodriguez, RIA TC Memo Paragraph number of the RIA Tax Court Memorandum decision reporter Robert Rodriguez, 85 TCM 1162 Volume 85 of the CCH Tax Court Memorandum reporter, (2005) page 1162, year 2005 U.S. Court of Federal J.R. Cohen v. U.S., 510 F. Supp. 297 Volume 510 of the West F. Supp. court reporter, page 297, Claims (Fed. Cl., 1993) year 1993 J.R. Cohen v. U.S., 72 AFTR2d Volume 72 of the RIA AFTR2d court reporter, paragraph , (Fed. Cl., 1993) year 1993 J.R. Cohen v. U.S., 93-1 USTC Volume 93-1 of the CCH USTC court reporter, paragraph 50,354, par. 50,354 (Fed. Cl., 1993) year 1993 U.S. District Court Waxler Towing Co., Inc. v. U.S., Volume 510 of the West F. Supp. court reporter, page 297, 510 F. Supp. 297 (W.D, TN, 1981) Western District (W.D.), state Tennessee, year 1981 Waxler Towing Co., Inc. v. U.S., 81-2 Volume 81-2 of the CCH USTC court reporter, paragraph 9,541, USTC par. 9,541 (W.D., TN, 1981) Western District (W.D.), state Tennessee, year 1981 Waxler Towing Co., Inc. v. U.S., Volume 48 of the RIA AFTR2d court reporter, paragraph , 48 AFTR2d (W.D., TN, 1981) Western District (W.D.), state Tennessee, year 1981

12 EXHIBIT 2-6 CHAPTER 2 Tax Compliance, the IRS, and Tax Authorities 2-11 Common Secondary Tax Authorities Tax Research Services: Professional Journals: BNA Tax Management Portfolios Journal of Accountancy CCH Standard Federal Tax Reporter Journal of Taxation CCH Tax Research Consultant Practical Tax Strategies RIA Federal Tax Coordinator Taxes RIA United States Tax Reporter Tax Adviser Newsletters: Daily Tax Report Federal Tax Weekly Alert Tax Notes Law Reviews: Tax Law Review (New York University School of Law) Virginia Tax Review (University of Virginia School of Law) Quick Reference Sources: IRS Publications CCH Master Tax Guide RIA Federal Tax Handbook Textbooks: McGraw-Hill s Taxation of Individuals and Business Entities McGraw-Hill s Essentials of Federal Taxation they hold little weight in a tax dispute (hence their unofficial status). Thus, tax advisers should always be careful to verify their understanding of tax law by examining primary authorities directly and to never cite secondary authority in a research memo. Exhibit 2-6 lists some of the common sources of secondary authority. TAXES IN THE REAL WORLD Google: Not Authoritative on Tax Matters While Internet super giant Google may be the king of all cyberspace knowledge, the Tax Court ruled in Woodard v. Comm., TC Summary Opinion , that a Google search does not constitute reasonable cause to excuse a Harvard MBA/CPA from taking an incorrect tax return position. The Tax Court noted that although the taxpayer had not worked as an accountant for years before filing his tax return, his accounting degree, MBA, and CPA training, no matter how stale, undoubtedly taught him what sources could be relied upon as definitive; such as, for example, the Internal Revenue Code and the income tax regulations, both of which are readily available on the Internet. Legislative Sources: Congress and the Constitution The three legislative or statutory tax authorities are the U.S. Constitution, the Internal Revenue Code, and tax treaties. The U.S. Constitution is the highest authority in the United States, but it provides very little in the way of tax law since it contains no discussion of tax rates, taxable income, or other details. Instead, the 16th Amendment provides Congress the ability to tax income directly, from whatever source derived, without apportionment across the states. Various attempts to amend the U.S. Constitution with regard to taxation for example, one effort to repeal the 16th Amendment entirely and one to require a twothirds majority in both houses to raise taxes have so far met with failure. Internal Revenue Code The second (and main) statutory authority is the Internal Revenue Code of 1986, as amended, known as the Code. The Internal Revenue Code has the same authoritative weight as tax treaties and Supreme Court rulings. Thus, a taxpayer should feel very confident in a tax return position, such as taking a deduction that is specifically allowed by the Code. The Internal Revenue Code is unique in that every other authority all administrative and judicial authorities except tax treaties

13 2-12 CHAPTER 2 Tax Compliance, the IRS, and Tax Authorities EXHIBIT 2-7 Tax Legislation Process House Ways and Means Committee 1. Proposed Tax Bill U.S. House of Representatives 6. Joint Conference Act 2. House Approved Act 7. Joint Conference Act U.S. Senate 3. House Approved Act Joint Conference Committee Senate Finance Committee 4. Revised Act 5. Senate Approved Act 9a. Signs the Act U.S. President 8. Joint Conference Act 9b. Vetoes the Act IRC of a. Yes Congressional override? 2/3 Majority Vote in Senate and House 10b. No RIP Tax Act RIP and the Constitution can be seen as an interpretation of it. Hence, understanding the relevant code section(s) is critical to being an efficient and effective tax professional. Congress enacts tax legislation virtually every year that changes the Code; 1986 was simply the last major overhaul. Prior to 1986, tax law changes were incorporated into the Internal Revenue Code of 1954, the year a new numbering system and other significant changes were introduced. Before that, tax law changes were incorporated into the Internal Revenue Code of 1939, which was the year of the first Code. The Legislative Process for Tax Laws Exhibit 2-7 illustrates the legislative process for enacting tax laws. As required by the U.S. Constitution (Article 1, Section 7), All bills for raising revenue shall originate in the House of Representatives. The Senate may propose tax legislation, but the first to formally consider a bill will be the House, typically within its Ways and Means Committee. After the committee debates the proposed legislation and drafts a bill, the bill goes to the House of Representatives floor for debate and ultimately a vote (either yea or nay without modification). If the bill is approved, it becomes an act and is sent to the Senate, which typically refers the

14 CHAPTER 2 Tax Compliance, the IRS, and Tax Authorities 2-13 act to the Senate Finance Committee. Not to be outdone by the House, the Senate Finance Committee usually amends the act during its deliberations. After the revised act passes the Senate Finance Committee, it goes to the Senate for debate and vote. Unlike representatives, senators may modify the proposed legislation during their debate. If the Senate passes the act, both the House and Senate versions of the legislation are sent to the Joint Conference Committee, which consists of members of the House Ways and Means Committee and the Senate Finance Committee. During the Joint Conference Committee deliberations, committee members debate the two versions of the proposed legislation. Possible outcomes for any specific provision in the proposed legislation include adoption of the Senate version, the House version, or some compromise version of the two acts. Likewise, the Joint Conference Committee may simply choose to eliminate specific provisions from the proposed legislation or fail to reach a compromise, thereby terminating the legislation. After the Joint Conference Committee approves the act, the revised legislation is sent to the House and Senate for vote. If both the House and Senate approve it, the act is sent to the president for his or her signature. If the president signs the act, it becomes law and is incorporated into the Internal Revenue Code of 1986 (Title 26 of the U.S. Code, which contains all codified laws of the United States). If the president vetoes the legislation, Congress may override the veto with a two-thirds positive vote in both the House and the Senate. The House Ways and Means Committee, Senate Finance Committee, and Joint Conference Committee each produce a committee report that explains the current tax law, proposed change in the law, and reasons for the change. These committee reports are considered statutory sources of the tax law and may be very useful in interpreting tax law changes and understanding Congressional intent. This is especially important after new legislation has been enacted because, with the exception of the Code, there will be very little authority interpreting the new law (i.e., no judicial or administrative authorities because of the time it takes for the new law to be litigated or for the IRS to issue interpretative guidance). Basic Organization of the Code The Internal Revenue Code is segregated into subtitles, chapters, subchapters, parts, subparts, and sections. All existing and any new tax laws are placed in the Code within a specific subtitle, chapter, subchapter, part, subpart, and section of the Code. When referencing a tax law, the researcher generally refers to the law simply by its code section. Code sections are numbered from 1 to 9833, with gaps in the section numbers to allow new code sections to be added to the appropriate parts of the Code as needed. Each code section is further segregated into subsections, paragraphs, subparagraphs, and clauses to allow more specific reference or citation. See Exhibit 2-5 for an example code citation and explanation. Memorizing the various subtitles and chapters of the Code has limited value (except to impress your friends at cocktail parties). However, understanding the organization of the Code is important, especially for the aspiring tax accountant. (See Exhibit 2-8.) First, you must understand the organization of a code section, its subsections, paragraphs, subparagraphs, and clauses to be able to cite the respective law correctly as, for example, IRC Sec. 162(b)(2). Second, note that many provisions in the Code apply only to specific parts of the Code. For example, it is quite common for a code section to include the phrase for purposes of this chapter,.... If you do not understand what laws are encompassed in the chapter, it would be very difficult for you to interpret the code section and determine its applicability to a research question. Finally, remember that code sections addressing similar transactions, such as deductions, or topics, such as C corporations, are grouped together. Consider a researcher faced with the question of whether an item of income is taxable. If the researcher understands the organization of the Code, she can quickly focus her research on code sections , which provide a broad definition of gross income, list items specifically included in gross income, and identify items specifically excluded from gross income. THE KEY FACTS Statutory Authorities U.S. Constitution The 16th Amendment provides Congress the ability to tax income directly, from whatever source derived, without apportionment across the states. Internal Revenue Code The main statutory authority is the Internal Revenue Code of The Internal Revenue Code has the same authoritative weight as tax treaties and Supreme Court rulings. Changes to the Code are passed by the House of Representatives and Senate and signed into law by the president. The House Ways and Means Committee and Senate Finance Committee oversee tax legislation in the House of Representatives and Senate, respectively. When referencing a tax law, the researcher generally refers to the law by its code section. Treaties Tax treaties are agreements negotiated between countries that describe the tax treatment of entities subject to tax in both countries.

15 2-14 CHAPTER 2 Tax Compliance, the IRS, and Tax Authorities EXHIBIT 2-8 Example of Code Organization Subtitle A Income Taxes Chapter 1 Income Taxes Subchapter A Determination of Tax Liability Part I Definition of Gross Income, Adjusted Gross Income, Taxable Income, etc. (Sec ) Sec. 61 Gross Income Defined Sec. 62 Adjusted Gross Income Defined Sec. 63 Taxable Income Defined Subsection 63(c) Standard Deduction Paragraph 63(c)(2) Basic Standard Deduction Subparagraph 63(c)(2)(A)... Clause 63(c)(2)(A)(i)... Part II Items Specifically Included in Gross Income (Sec ) Sec. 71 Alimony Sec. 72 Annuities Sec. 73 Services of Child Sec. 74 Prizes & Awards -... Part III Items Specifically Excluded from Gross Income (Sec ) Sec. 101 Certain Death Benefits Sec. 102 Gifts and Inheritances Sec. 103 Interest on State & Local Bonds Tax Treaties Tax treaties are negotiated agreements between countries that describe the tax treatment of entities subject to tax in both countries, such as U.S. citizens earning investment income in Spain. The U.S. president has the authority to enter into a tax treaty with another country after receiving the Senate s advice. If you are a U.S. citizen earning income abroad or an accountant with international clients, you need knowledge of U.S. tax laws, the foreign country s tax laws, and the respective tax treaty between the U.S. and the foreign country for efficient tax planning. Because the focus in this text is on U.S. tax laws, we only briefly mention the importance of tax treaties as a statutory authority. Example 2-2 THE KEY FACTS Judicial Authorities Our judicial system is tasked with the ultimate authority to interpret the Internal Revenue Code and settle disputes between taxpayers and the IRS. The Supreme Court is the highest judicial authority. Beneath the Supreme Court, the decisions of the 13 Circuit Courts of Appeal represent the next highest judicial authority. Bill recently spent a summer in Milan, Italy, teaching a graduate level economics course. While in Italy he earned a $20,000 stipend from Bocconi University and some interest in a temporary banking account that he established for the trip. What tax laws must Bill consider to determine the taxation of his $20,000 stipend? Answer: U.S. tax laws, Italian tax laws, and the U.S. Italy tax treaty will determine the tax consequences of the amounts Bill earned in Italy. Judicial Sources: The Courts Our judicial system has the ultimate authority to interpret the Internal Revenue Code and settle disputes between the IRS and taxpayers. As Exhibit 2-3 illustrates, there are five basic sources of judicial authority (three trial-level courts, 13 U.S. Circuit Courts of Appeal, and the Supreme Court). We ve noted that the Supreme Court, along with the Code, represents the highest tax-specific authority. An important distinction between the two, however, is that the Supreme Court does not establish law, but instead simply interprets and applies the Code (along with other authorities). Thus, the Code and the Supreme Court should never be in conflict The Supreme Court does have the authority to declare a Code provision unconstitutional.

16 CHAPTER 2 Tax Compliance, the IRS, and Tax Authorities 2-15 Below the Supreme Court, the decisions of the 13 U.S. Circuit Courts of Appeal represent the next highest judicial authority. The lowest level of judicial authority consists of three different types of trial-level courts (94 U.S. District Courts that hear cases involving taxpayers that reside within their respective district, the U.S. Court of Federal Claims, and the U.S. Tax Court). Given that the U.S. Tax Court hears only tax cases and that its judges are tax experts, its decisions typically have more weight than those rendered by a district court or the U.S. Court of Federal Claims. 11 Likewise, because the U.S. Court of Federal Claims hears a much narrower set of issues than U.S. District Courts (only monetary claims against the U.S. government), its decisions have more weight than district court decisions. In rendering court decisions, all courts apply the judicial doctrine of stare decisis. This doctrine means that a court will rule consistently with (a) its previous rulings (unless, due to evolving interpretations of the tax law over time, the court decides to overturn an earlier decision) and (b) the rulings of higher courts with appellate jurisdiction (the courts its cases are appealed to). The implication of stare decisis is that a circuit court will abide by Supreme Court rulings and its own rulings, whereas a triallevel court will abide by Supreme Court rulings, its respective circuit court s rulings, and its own rulings. For example, a district court in California would follow U.S. 9th Circuit and Supreme Court rulings as well as the court s own rulings. The doctrine of stare decisis presents a special problem for the U.S. Tax Court because it appeals to different circuit courts based on the taxpayer s residence. To implement the doctrine of stare decisis, the tax court applies the Golsen rule. 12 The Golsen rule simply states that the tax court will abide by rulings of the circuit court that has appellate jurisdiction for a case. The lowest level of judicial authority consists of three different types of trial-level courts (U.S. District Courts, U.S. Court of Federal Claims, and the U.S. Tax Court). U.S. Tax Court decisions typically are considered to have more authoritative weight than decisions rendered by a district court or the U.S. Court of Federal Claims. All courts apply the judicial doctrine of stare decisis, which means that a court will rule consistently with its previous rulings and the rulings of higher courts with appellate jurisdiction. Example 2-3 What if: If Bill and Mercedes opt to litigate their case in tax court, by which circuit court s rulings will the tax court abide? Answer: Because Bill and Mercedes live in Florida, the U.S. Tax Court will abide the circuit court with appellate jurisdiction in Florida, which happens to be U.S. 11th Circuit Court. Administrative Sources: The U.S. Treasury Regulations, Revenue Rulings, and Revenue Procedures The Treasury Department, of which the IRS is a bureau, is charged with administering and interpreting the tax laws of the United States, among other duties such as printing money and advising the president on economic issues. Regulations are the Treasury Department s official interpretation of the Internal Revenue Code, have the highest authoritative weight, and often contain examples of the application of the Code that may be particularly helpful to the tax researcher. Regulations are issued in three different forms: final, temporary, and proposed. The names are very descriptive. Final regulations are regulations that have been issued in final form, and thus, unless or until revoked, they represent the Treasury s interpretation of the Code. Temporary regulations have a limited life (three years for regulations issued after November 20, 1988). Nonetheless, during their life, they carry the same authoritative weight as final regulations. Finally, all regulations are issued in the form of proposed regulations first, to allow public comment on them. Proposed regulations do not carry the same authoritative weight as temporary or final regulations. In addition to being issued in three different forms, regulations also serve three basic purposes: interpretative, procedural, and legislative. Most regulations are issued as 11 The Tax Court renders both regular and memorandum decisions. Regular decisions involve new or unusual points of law, whereas memorandum decisions involve questions of fact or the application of existing law. Both decisions have similar authoritative weight. Decisions issued by the Tax Court's Small Claims division may not be cited as precedent TC 742 (1970). THE KEY FACTS Administrative Authorities The Treasury Department is charged with administering and interpreting the tax laws. Regulations Regulations are the Treasury Department s official interpretation of the Internal Revenue Code and have the highest authoritative weight. Regulations are issued in three different forms (proposed, temporary, and final) and serve three basic purposes (interpretative, procedural, and legislative). (continued)

17 2-16 CHAPTER 2 Tax Compliance, the IRS, and Tax Authorities Revenue rulings and revenue procedures Revenue rulings and revenue procedures are second in administrative authoritative weight after regulations. Revenue rulings address the application of the Code and regulations to a specific factual situation. Revenue procedures explain in greater detail IRS practice and procedures in administering the tax law. Letter rulings Letter rulings are less authoritative but more specific than revenue rulings and regulations. Private letter rulings represent the IRS application of the Code and other tax authorities to a specific transaction and taxpayer. interpretative or procedural regulations. As the names suggest, interpretative regulations represent the Treasury s interpretation of the Code. In Bill and Mercedes s case, these might be the regulations issued under IRC Sec. 163, which discuss interest deductions. Procedural regulations explain Treasury Department procedures as they relate to administering the Code. Again, for Bill and Mercedes s case, these might be the regulations issued under IRC Sec regarding the statute of limitations for IRS assessment and collection. Legislative regulations, the rarest type, are issued when Congress specifically directs the Treasury Department to create regulations to address an issue in an area of law. In these instances, the Treasury is actually writing the law instead of interpreting the Code. Because legislative regulations represent tax law instead of interpretation of tax law, legislative regulations generally have been viewed to have more authoritative weight than interpretative and procedural regulations. However, in Mayo Foundation for Medical Education & Research v. U.S., 131 S.Ct. 704 (2011), the Supreme Court held (subject to specific conditions) that all Treasury regulations warrant deference. Accordingly, it is a very difficult process to challenge any regulation and thus, taxpayers are cautioned not to take tax return positions inconsistent with regulations. Revenue rulings and revenue procedures are second in administrative authoritative weight after regulations. But unlike regulations, revenue rulings address the application of the Code and regulations to a specific factual situation. Thus, while revenue rulings have less authoritative weight, they provide a much more detailed interpretation of the Code as it applies to a specific transaction and fact pattern. For example, Rev. Rul discusses the deductions of prepaid interest (points) a taxpayer may claim when refinancing the mortgage for a principal residence, whereas the Code and regulations do not specifically address this issue. Although revenue rulings are binding on the IRS (until revoked, superseded, or modified), courts may agree or disagree with a revenue ruling. Thus, while revenue rulings should be carefully evaluated as they represent the IRS s interpretation, courts may provide a different interpretation of the tax law that a taxpayer might choose to follow. Revenue procedures are also much more detailed than regulations. They explain in greater detail IRS practice and procedures in administering the tax law. For example, Rev. Proc provides the specific depreciation lives for depreciable assets (discussed in Chapter 9). As with revenue rulings, revenue procedures are binding on the IRS until revoked, modified, or superseded. Letter Rulings Below revenue rulings and revenue procedures in authoritative weight rest letter rulings. As you might guess, letter rulings are less authoritative but more specific than revenue rulings and regulations. Letter rulings generally may not be used as precedent by taxpayers. However, they may be cited as authority to avoid the substantial understatement of tax penalty under IRC Sec imposed on taxpayers and the related tax practitioner penalty under IRC Sec (discussed later in this chapter). Private letter rulings represent the IRS s application of the Code and other tax authorities to a specific transaction and taxpayer. Private letter rulings are issued in response to a taxpayer request and are common for proposed transactions with potentially large tax implications. For example, companies commonly request a private letter ruling to ensure that a proposed corporate acquisition meets the definition of a taxfree exchange. However, the IRS also maintains a list of certain issues on which it refuses to rule, such as the tax consequences of proposed federal tax legislation. Each year, the IRS publishes an updated list of these transactions in a revenue procedure. Other types of letter rulings include determination letters and technical advice memorandums. Determination letters, issued by local IRS directors, are generally not controversial. An example of a determination letter is the request by an employer for the IRS to rule that the taxpayer s retirement plan is a qualified plan. Technical advice memorandums differ from private letter rulings in that they are generated for completed transactions and usually are requested by an IRS agent during an IRS audit. Is this a comprehensive list of IRS pronouncements? No. In addition to the pronouncements listed above, the IRS issues several less common types, which are beyond the scope of this text. A couple of other pronouncements, however, warrant some

18 CHAPTER 2 Tax Compliance, the IRS, and Tax Authorities 2-17 discussion. As we mentioned above, the IRS and taxpayers litigate tax cases in a number of courts and jurisdictions. Obviously, the IRS wins some and loses some of these cases. Except for Supreme Court cases, whenever the IRS loses, it may issue an acquiescence or nonacquiescence as guidance for how the IRS intends to respond to the loss. Although an acquiescence indicates that the IRS has decided to follow the court s adverse ruling in the future, it does not mean that the IRS agrees with it. Instead, it simply means that the IRS will no longer litigate this issue. A nonacquiescence has the exact opposite implications and alerts taxpayers that the IRS does plan to continue to litigate this issue. Finally, the IRS also issues actions on decisions, which explain the background reasoning behind an IRS acquiescence or nonacquiescence. 13 What are noticeably absent from the list of administrative authorities? IRS publications and tax return form instructions. Neither can be cited as precedent or relied upon to avoid taxpayer or tax practitioner penalties. TAX RESEARCH Now that you have a basic understanding of the different types of tax authority, why do you think that the IRS and taxpayers disagree with respect to the tax treatment of a transaction? In other words, why would the IRS and Bill and Mercedes s CPA reach different conclusions regarding the deductibility of certain expenses? The answer is that, because the Code does not specifically address the tax consequences of each transaction type or every possible variation of a particular transaction, the application of the tax law is subject to debate and differing interpretations by the IRS, courts, tax professionals, taxpayers, and so on. Tax research, therefore, plays a vital role in allowing us to identify and understand the varying authorities that provide guidance on an issue, to assess the relative weights of differing authorities, to understand the risks associated with different tax return positions, and ultimately to draw an appropriate conclusion regarding the application of the tax law to the issue. The following paragraphs describe the basic process of tax research that tax professionals use to identify and analyze tax authorities to answer tax questions. We will then revisit Bill and Mercedes s issue and view the research memo prepared by their CPA. Step 1: Understand Facts To answer a tax question, you must understand the question. To understand the question, you must know the facts. There are two basic types of facts: open facts and closed facts. Open facts have not yet occurred, such as the facts associated with a proposed transaction. Closed facts have already occurred. The distinction between open and closed facts is important because, unlike closed facts, open facts can be altered, and different facts may result in very different tax consequences. Open facts allow the taxpayer to arrange a transaction to achieve the most advantageous outcome. Thus, they are especially important in tax planning. How do you determine the facts for a research question? Interview clients, speak with third parties such as attorneys and brokers, and review client documents such as contracts, prior tax returns, wills, trust documents, deeds, and corporate minutes. When interviewing clients, remember that not many are tax experts. Thus, it is up to the tax professional to ask the correct initial and follow-up questions to obtain all the relevant facts. Also consider nontax factors, such as a client s personal values or objectives, as these often put constraints on tax planning strategies. Step 2: Identify Issues A tax professional s ability to identify issues is largely a function of his or her type of tax expertise. A tax expert in a particular area will typically be able to identify quickly the 13 Actions on decisions have no precedential value but may be cited as authority to avoid the substantial understatement of tax penalty under IRC Sec imposed on taxpayers and the related tax practitioner penalty under IRC Sec (discussed later in this chapter). THE KEY FACTS Tax Research The five steps in tax research are (1) understand the facts, (2) identify issues, (3) locate relevant authorities, (4) analyze the tax authorities, and (5) document and communicate research results. The two types of tax services that tax professionals use in tax research are annotated tax services, arranged by code section, and topical services, arranged by topic. Research questions often consist of questions of fact or questions of law. The answer to a question of fact hinges upon the facts and circumstances of the taxpayer s transaction. The answer to a question of law hinges upon the interpretation of the law, such as interpreting a particular phrase in a code section. When the researcher identifies that different authorities have conflicting views, she should evaluate the hierarchy, jurisdiction, and age of the authorities. Once the tax researcher has identified relevant authorities, she must make sure that the authorities are still valid and up to date. (continued)

19 2-18 CHAPTER 2 Tax Compliance, the IRS, and Tax Authorities The most common end product of a research question is a research memo, which has five basic parts: (1) facts, (2) issues, (3) authority list, (4) conclusion, and (5) analysis. specific tax issues that relate to transactions in that area. For example, an expert in corporate acquisitions would quickly identify the tax consequences and specific issues of alternative acquisition types. A novice, on the other hand, would likely identify broader issues first and then more specific issues as he or she researched the relevant tax law. What s the best method to identify tax issues? First of all, get a good understanding of the client s facts. Then, combine your understanding of the facts with your knowledge of the tax law. Let s consider the example of Bill and Mercedes s interest deduction. For an expert in this particular area, the issues will be immediately evident. For a novice, the initial response may take the form of a series of general questions: (1) Is this item of expense deductible? (2) Is that item of income taxable? (3) In what year should the expense be deducted? (4) In what year should the item of income be taxed? After you identify these types of general issues, your research will enable you to identify the more specific issues that ultimately determine the tax ramifications of the transaction. Example 2-4 Elizabeth, Bill and Mercedes s friend who is a shareholder and the CFO of a company, loaned money to her company to help prevent the company from declaring bankruptcy. Despite Elizabeth s loan, the company did file bankruptcy, and Elizabeth was not repaid the loan. What issues would a researcher consider? Answer: The first questions to ask are whether Elizabeth can deduct the bad debt expense and, if so, as what type of deduction? As the researcher delves more into the general issue, he would identify that the type of deduction depends on whether Elizabeth s debt is considered a business or nonbusiness bad debt. This more specific issue depends on whether Elizabeth loaned the money to the company to protect her job (business bad debt) or to protect her stock investment in the company (nonbusiness bad debt). Bad debt expenses incurred for nonbusiness debts (investment-related debts) are deducted as capital losses and thus subject to limitations (discussed in Chapter 11), whereas bad debt expenses for business debts (business-related debts) are ordinary deductions and not limited. Why might this case be a good one to litigate in U.S. District Court? Answer: Because a jury might be more likely to be convinced to assess Elizabeth s motives favorably. Step 3: Locate Relevant Authorities Step three in the research process is to locate the relevant authorities (code sections, regulations, court cases, revenue rulings) that address the tax issue. Luckily, tax services can aid the researcher in identifying relevant authorities. Most, if not all, of these services are available on the Internet (with a subscription), and thus offer the flexibility to conduct research almost anywhere. 14 There are two basic types of tax services: annotated and topical. Annotated tax services are arranged by Internal Revenue Code Section. That is, for each code section, an annotated service includes the code section; a listing of the code section history; copies of congressional committee reports that explain changes to the code section; a copy of all the regulations issued for the specific code section; the service s unofficial explanation of the code section; and brief summaries (called annotations) of relevant court cases, revenue rulings, revenue procedures, and letter rulings that address issues specific to the code section. Two examples of annotated tax services are Commerce Clearing House s (CCH) Standard Federal Tax Reporter and Research Institute of America s (RIA) United States Tax Reporter contains a lot of information (tax forms, IRS publications, etc.) that may be especially useful for answering basic tax questions. In addition, tax publishers, such as CCH and RIA, produce quick reference tax guides (e.g., the CCH Master Tax Guide or the RIA Tax Handbook) that may be used to answer basic tax questions.

20 CHAPTER 2 Tax Compliance, the IRS, and Tax Authorities 2-19 Topical tax services are arranged by topic, such as taxable forms of income, taxexempt income, and trade or business expenses. For each topic, the services identify tax issues that relate to each topic, and then explain and cite authorities relevant to the issue (code sections, regulations, court cases, revenue rulings, etc.). Beginning tax researchers often prefer topical services, because they generally are easier to read. Some examples of topical federal tax services include BNA s Tax Management Portfolios, CCH s Tax Research Consultant, and RIA s Federal Tax Coordinator. How does a researcher use these services? An expert would probably go directly to the relevant portions of an annotated or topical service. A novice may conduct a keyword search in the service, use the tax service s topical index, or browse the tax service to identify the relevant portions. Some suggestions for identifying keywords: Try to describe the transaction in three to five words. An ideal keyword search typically includes (1) the relevant area of law and (2) a fact or two that describes the transaction. Try to avoid keywords that are too broad (income, deduction, taxable) or that may be too narrow. Bill and Mercedes refinanced the mortgage on their principal residence a couple of years ago when their original mortgage s four-year balloon payment came due. Their mortgage institution charged Bill and Mercedes $3,000 of points (prepaid interest) upon the refinancing in order to give them a reduced interest rate. On their CPA s advice, Bill and Mercedes deducted the $3,000 in the year they paid it, but upon audit, the IRS disallowed the deduction. What is the research issue? Answer: The issue is, should Bill and Mercedes have deducted the $3,000 of points in the year they paid it? What are some keywords that could identify relevant tax authority? Answer: Points (area of law), interest (area of law), refinancing (fact that describes the transaction). Example 2-5 Keyword searching is more an art than an exact science. As you gain a better understanding of different areas of the tax law, you ll become much more efficient at using keywords. If keyword searching is not proving beneficial, check your spelling, make sure you re searching within the correct database, rethink your keywords, use another research method, use another tax service, or as a last resort, take a break. While utilizing keyword searches or other research methods to identify potentially relevant areas of law and tax authorities, constantly ask yourself whether you are indeed in the correct area of law. Once the answer to this question is an authoritative yes, you can delve deeper into the area of law and related authorities to answer the question. Step 4: Analyze Tax Authorities Once a researcher identifies relevant authorities, she must read carefully to ensure she fully understands them, as well as their application to the research problem. Two basic types of issues researchers will encounter are questions of fact and questions of law. The answer to a question of fact hinges upon the facts and circumstances of the taxpayer s transaction. For example, whether a trade or business expense is ordinary, necessary, reasonable, and thus deductible, is a question of fact. If you re researching a question of fact, understand which facts determine the answer in this case, which facts make an expense ordinary, necessary, and reasonable and which do not. In this type of question, the researcher will focus on understanding how various facts affect the research answer and identifying authorities with fact patterns similar to her client s. The answer to a question of law hinges upon the interpretation of the law, such as interpreting a particular phrase in a code section (see the sample research memo in Exhibit 2-9 for an example of a question of law). If a researcher is faced with this type